I'm trying to model an LBO where I am the buyer and am offering to pay 8x $100M LTM EBITDA, but 5x up-front, with the rest paid over 3 years as revenue targets are hit. How do you do this on the model (I'm asking about the concept, not the mechanics of how much they get)?
I'm thinking it should probably be on sources & uses, get put onto the company's balance (even though this is money "I" am paying out of "my" pocket in future years), and then get put into the cash flow statement? But I really don't know. This wasn't in any course I took.
I'm really lost.
You'd have the earnout as a contingent liability on the balance sheet, and as targets are met, you would build into the model the payout and corresponding decrease in the contingent liability. The contingent liability would need to be placed on the books at fair market value and re-evaluated at every reporting period. Those changes would flow through the income statement as a gain/loss.
You would need the specific terms of the agreement to properly model it, though.
I guess the easiest way to think of it as a zero interest cash flow sweep loan, with the terms of the cash flow sweep being the terms of the earnout. The only difference of course is that it has to be evaluated to fair market value in each reporting period. I don't know if this helps at all.
That really helps. Thank you @Khayembii. When and how do I pay it though? Do I buy this company as if the EV is the whole $800M right away, but the equity holders only get cashed out as if it was $500M, so then the $300M contingent liability gets booked, and my $300M just sits there?
I'm lost on that part. Of course I don't want the earn-out to leave my pocket until it's earned, so how does that get reflected?
Thank you!!
He discussed how you model it. You need to reread his post.
Earnouts are structured where mgmt (and/or prior ownership) gets paid based on hitting targets (generally EBITDA, but could be something else). So, create a simple if statement that reads, if EBITDA is greater or equal to X, Y% of the earnout is paid out to the mgmt/sellers. Do this for each year until you burn out the $300mm.
Typically, these agreements only last ~3 years, though you could model it out to 5.
That really helps. Thank you @Khayembii. When and how do I pay it though? Do I buy this company as if the EV is the whole $800M right away, but the equity holders only get cashed out as if it was $500M, so then the $300M contingent liability gets booked, and my $300M just sits there?
I'm lost on that part. Of course I don't want the earn-out to leave my pocket until it's earned, so how does that get reflected?
Thank you!!
bump
Interested in how an earnout would be reflected in sources and uses
Equity account
Not necessarily. Depends how you fund it. If you raise debt or fund the earn out off a revolver for example, you trade that liability. maybe you generate some cash and fund the earn out that way too.
Worth noting, if it's a material earn out, be sure to get your taxes right. I.e. if allocating to goodwill, you amortize the earn-out over the remaining 15 yrs from when you did the initial deal. So if you do a deal and don't pay earnout for another two years, typically you amortize that earn-out for tax purposes over 13 years.
I'm confused here about where the cash comes from for the earn-out. So they hypothetically sell 80% of the equity to me for $400M up-front, and we agree that I will pay them another $240M in 3 years if the company hits its targets. I just want to make sure to understand what happens next and why.
The fact that I said I will pay them the $240M is irrelevant, right? The cash isn't going to come from my pocket, it's going to come from the company's cash flows, i.e., the 20% that they still own is going to lose some value to fund the earn-out payment. Does that sound correct?
If so, you book a contingent liability on the balance sheet. So on day one, in the case of the sources & uses above, the new equity account would be 20.6+20+52.5-transactioncosts. But then you book the 20.6 contingent liability as well, reducing the equity account by 20.6. Does that all sound right?
And then when you finally pay it, the company simply pays it, reducing the liability and cash. Unless they didn't hit the targets, in which case you simply write off the liability and book a gain to increase the equity account by the amount you wrote off.
Where did I miss?
Yes, but of course the buyer doesn't say that "they" will pay the earnout, they say the Company will. So you'd sell the company for $400mm plus the fair value of the earn out at close. Technically the buyer and seller aren't agreeing on a purchase price due to the contingent liability, however the earn out would be valued in this theoretical purchase price at fair value. So the liability would be recognized on the opening balance sheet.
Why are you including the earn out in equity initially? The opening balance sheet would have it as a liability so it wouldn't be in the equity account.
AFAIK this is correct, assuming it's funded off cash as the other poster said above.
Define: Earnout (Originally Posted: 08/01/2009)
In the context of an acquisition, what is an earnout?
If someone says, "Assume earnouts of $XX going forward..." what does this mean?
Thanks!
Hmm, well, in real estate, an earnout is when the lender has agreed to give the borrower more loan dollars if the borrower meets certain conditions. For example, a lender might issue a $2 million loan with an earnout of $500,000 (additional debt capital) if occupancy is rasied from 88% to 95%. I would assume in your case that this means a firm or company can acquire more capital if it meets certain criteria.
An earnout is considered to be an alternative to an equity stake. It's a transaction structure involving rebates or royalties based on company profits.
Got it. Thanks.
An Earn-Out is a provision whereby the buyer agrees to pay a base price but this does not reflect the full value the seller believes the business to be worth. However, in the future, the buyer promises to pay additional consideration up to that full value if pre-negotiated financial milestones are achieved in the future.
So, as an over-simplified example, Seller wants to sell Business X for $100M, Buyer only wants to purchase for $75M because he is unsure if Business X is truly worth $100M. If they agree to an earn-out, Buyer will purchase it for $75M but promises to pay Seller an extra $25M if, in running Business X over the next year or so, certain finanical targets are met.
So, "assume earnouts of $XX going forward" I believe, means, that assume the pre-negotiated financial targets are met and that the buyer will pay the seller the additional consideration.
DDGM1112's definition is how it is used in m&a in my group. A small deal we are closing on now will pay $95mm at closing and $30mm in cash/stock earnout if ebitda targets are met over the next year.
Anyone know how an earnout flows through a model? (Originally Posted: 06/10/2015)
Hey guys, so I am trying to model out this LBO we are doing to figure out our projected returns. For some reason someone thought it would be a good idea to give the management an earnout instead of a bonus or whatever. Seemed like a good idea until I now have to model it in.
The potential earnout is $10mm, with $6mm paid the first year and $4mm the second year, if management beats the EBITDA threshold we set. Trying to figure out how this flows through the statements, though. Obviously it gets thrown onto the P&L if/when they beat the threshold, but does it go on the BS or anywhere else?
I have heard these are pretty common in smaller LBOs and stuff, so hopefully someone has been through this and could shed some light. Thanks in advance.
Awesome man, thanks. You earned the SB.
earnouts dont go on sources & uses because its a potential future payout
This is incorrect. It does go on the S&U. Please don’t spread misinformation if you don’t fully understand something.
This is incorrect. It does go on the S&U. Please don’t spread misinformation if you don’t fully understand something.
This is incorrect. It does go on the S&U. Please don’t spread misinformation if you don’t fully understand something.
Your S&U output can show the total EV including the earn out in a “step 1 / step 2” type thing.
But don’t put it in the actual S&U that is linked to the model right, otherwise you might fuck up the model itself. The earn out payment should be debt financed as long as it works with coverage ratios. It’s basically just like a $100m or whatever cash out flow right? Not much more complicated than that. For simplicity, just assume that any rollover investors are rolling pro rata into the earn out. Then remember, no new shares since it’s just deferred and contingent purchase price - it increases your TEV multiple.
Not much expirience with earn outs in LBOs. How commonly do you see earn out satisfied by a cash sweep post interest coverage?
Or is it p much always funded by debt?
You do do that sometimes.
However, it is really not so different from the perspective of a model right — since it is coming out in net debt regardless. A little extra interest expense — sure.
But you generally aren’t rolling in FCF, maybe you are though. The other thing — if the sellers rolled rolled then maybe you don’t own all the FCF such that you can pay them with it.
Usually it’s equity. Deals with long dated contingent elements typically don’t win. As the sellers lose control. So they don’t want their money at risk of issues you might create as a new owner etc. And money now vs money later etc. Most commonly it’ll be a ‘hit the budget’ earn out in large deals. And for the earn out to have any meaning it’ll have to be big enough that realistically it can’t be financed from debt or cash in full or for much.
Are earnouts typically funded from the company balance sheet now? If so, that would technically "dilute" a management team's rollover equity in the sense that you're taking cash out of the business to fund the earnout.
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